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On December 1, we learned that the economy has been in an official recession since December 2007, according to the National Bureau of Economic Research (NBER). The economy lost 533,000 jobs last month, the most in 34 years, which puts the official unemployment figure at 6.7%. The 3-month figure is negative 1.3 million, the third highest 3-month figure since WW II. Two-thirds of the 1.9 million total job loss during this recession has occurred in the last three months. Approximately 1.6 million jobs were destroyed in the 2001 “dot com recession.”

If you look outside, down the street, around the neighborhood, however, things probably still appear little changed. No one who wasn’t already selling pencils has started that low-overhead business. Most people you know still have jobs and drive the same cars.

U-Turn & Round Trip

That’s part of the problem, according to John Bergstrom of Bergstrom Automotive, Wisconsin’s largest auto dealership, with 33 franchises representing 25 brands from BMWs to Buicks, Honda’s to Hummer’s, Prius’ to Porsches. In an interview on CNBC this week, Mr. Bergstrom expressed confusion about why people are not buying new vehicles from Detroit, especially given the high quality products that get an impressive 21 mpg. Bergstrom commented that it now seems “politically incorrect” to spend money.

To correct that misperception, Bergstrom proposed a dual $10,000 stimulus program for willing new car buyers, half underwritten by a rebate from the auto manufacturers and half by federal taxpayers. Bergstrom’s proposal, the Consumer Re-stimulation Assistance Program (CRAP), would be an adjunct to the TARP. Bergstrom is reported to be considering throwing in a free oil change.

We hope Mr. Bergstrom will forgive us for having a little fun at his expense. His $10K proposal is real (the name and the free oil change are not) and he is no doubt sincere and well-meaning, as it would help stimulate the broader economy, not to mention serving as a nice holiday going-away present to the many auto dealers who are likely to lose their franchises next year in the coming bankruptcy and downsizing of the industry. No one can fault Bergstrom for talking his book, but we would not go to industry players for objective analysis. We learned that lesson from Wall Street executives this year, did we not?

According to a Deutsche Bank research analyst, the auto sector has been suffering from a mismatch between what Detroit wants to make (high margin pickups and SUVs) and what consumers want to buy (low margin smaller, more efficient vehicles). If that were the only problem, however, it would be a simple matter of retooling for changing customer demand. Unfortunately, the mismatch in the supply/demand profile is being exacerbated by a serious recession and a credit crisis. As a result, U.S. auto sales, which have averaged 16.8 million units a year over the last decade, are currently annualized at a bit more than half that amount, based on November’s 747,000 unit pace. Auto sales peaked in October of 2007, right along with the equity market and are now at the same level they were when the 25-year secular bull market in equities began in 1982, completing a very sudden and perhaps symbolic U-turn and round trip.

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Meanwhile, just about everything in America is on sale for 40%-50% off. Equities are the first thing that comes to mind. One can buy shares of the average large-cap, mid-cap or small-cap stock at around half-price compared to its peak markup. Meanwhile, top tier educational and financial institutions are also finding the value of their private equity holdings has been halved, as well. Private equity funds raise capital from, say, the endowment fund of an institution such as Harvard and typically deploy it in leveraged buyouts. The operative word is ‘leveraged.’

The LBO game requires the participation of large banks that assist in the financing, allowing a private equity company to control 5-10 times its cash investment. In good times, that type of deal can produce outsized gains for the LBO partners and a handsome return for the institution over a 3-5 year period. With banks pulling in horns, however, those days are over. Moreover, many existing deals are short-term and require refinancing, which is no longer available. Thus the general writedown.

In the commodity sector, gasoline has fallen to half its peak price in 2008 along with just about every other energy, agricultural or industrial commodity, including silver. Did you assume $45-$50 would be rock bottom for crude? Well, think again. A commodity analyst at Merrill Lynch opines that crude oil could fall below $25 in 2009, if China enters a recession. Crude, perhaps the other commodity with a Ph.D., is forecasting a global recession of Armageddon-like proportions in 2009.

Of course, crude may not have a Ph.D., it may simply be expressing the natural pendulum swing of a speculative bubble deflating. Crude futures are not just economically sensitive; they are also highly liquid (!) trading vehicles. We know that not only hedge funds, but also some institutional funds (retirement and pension funds) were participating in the oil futures market in the last few years, seeking to outperform the comparatively sluggish indices. There was some objection to that practice, of course, as critics believed it was fueling unnecessary price inflation.

We expect that the institutional investors who ventured into the commodity playground with some naivete, are now approaching the point of maximum pain as oil flirts with the $40 area. A temporary plunge below $40 is likely to create a capitulatory event that will shake out all weak hands. Once everyone hates the energy sector as they hated tech in late 2002, conditions will be in place for a final bottom.

On the retail front, the Institute of Supply Management (ISM) index of “non-manufacturing” business fell in November to its lowest level since the data began to be tracked 11 years ago. Gratefully, the post-Thanksgiving weekend proved to be a relief for retailers, however, as sales were brisk, but consumers focused on the heavily discounted items, which were typically marked down 50%.

Bear in a China Shop

We know things are bad here at home, but don’t think for a minute that China is going to escape unscathed. A leading Asian economist expects China’s economy to grow 0% to 4% next year, with a 30% chance of a negative number. His are the lowest estimates we have seen (the World bank estimates 7.5%; while Merrill Lynch expects 8.6%), but we think we should pay attention to the skeptic. During systemic corrections, bad things tend to get worse than expected as the synergistic forces of contraction create self-reinforcing negative spirals. We saw that clearly in the financial sector this year as banks suddenly hit walls no one knew were there.

China has been growing at 10% annually for 30 years, boosting GDP 6900% since 1978, when economic reforms began. A deceleration from 10% to 0% in just a few quarters will produce dangerous G-forces. At such a low level of growth, China is going to have severe civil unrest, pockets of which are already apparent.

China, not the U.S., is the world’s largest metals buyer, which is why commodity prices have been falling so sharply. It is therefore the global bellwether and catalyst for any commodity recovery. Until China is pronounced healthy, commodities are trash. Property price declines, not commodity deflation, will be at the epicenter of the Chinese contraction, however, just as in the U.S. Real estate prices in Shanghai fell 19% in Q3 on a sequential basis. Real estate corrections are notoriously slow, so we can expect a multi-year global downturn.

We think China will use its healthy balance sheet and $1.9 trillion in foreign currency reserves to cushion the blow from a global recession and downshift the economy to a sustainable level of growth in the 5% range over the next few years. Meanwhile, Western economies are unlikely to be able to grow at anything near that pace, if at all, while they are downsizing, deleveraging and de-risking. That one discrepancy in long-term economic prospects between East and West will have enormous negative impact on equity values in the U.S. over time.

Global Domino Effect

There are a number of Emerging Market dominos likely to fall before we have to deal with the big one, China. Last month Ecuador failed to pay interest on its government bonds. By Monday, December 15th, Ecuador will need to make another payment and make up for the one it missed or it will be in default. Countries like Ecuador are scrambling to get loans from solvent, cash-rich countries, but the handouts are not forthcoming.

There is another potential global credit tsunami on the way, as well, namely the potential default of the debt of emerging market countries. European banks have lent emerging nations about $3.5 trillion, five times more than U.S. banks, according to the Bank for International Settlements. If that debt gets downgraded due to defaults, watch out.

Save or Spend?

Lastly, there are two approaches to heading off the recession, one emphasizes saving and the other spending. The risk of the savings scenario is that consumption falters so much that a deflationary spiral ensues. The risk of the spending stimulus scenario is that it may encourage the same type of irresponsible behavior that caused the crisis in the first place (moral hazard) and simply postpones the inevitable. China’s central bank governor, Zhou Xiaochuan said this week at an economic summit that China is preparing for the worst case scenario in the U.S. and hopes the U.S. will emphasize savings over consumption.

That said, coordinated stimulus by the world’s central banks and governments is likely to be the primary response. The European Central Bank cut its benchmark rate by 3/4 of a point this week, the sharpest reduction ever. The Bank of England slashed another percentage point off its target rate this week, taking it down to 2%, the lowest level since…get this… 1951. David Rosenberg Chief North American economist at Merrill Lynch believes, “Investors should operate under the assumption that the Fed is going to embark on a new course of balance sheet expansion to mitigate the downside risks to the macro outlook and fight the looming deflation battle.”

Bernanke has criticized the Bank of Japan for not taking sufficiently flexible and vigorous measures to stimulate the Japanese economy. Rather the BOJ was overly worried about inflation. Unlike the BOJ, the Fed and Treasury have introduced dozens of new measures aimed at getting the economic heart pumping again on its own again. Specifically, the Fed has more than doubled the size of its balance sheet, which now stands at $2.1 trillion, since the level from September 10, just prior to Lehman Brothers’ bankruptcy filing.

We think the current economic situation has deflationary aspects which may be positive, i.e. a general shift in attitude from consumption to conservation. We think this shift in orientation will eventually affect most aspects of the U.S. economy, muting exuberance and instilling caution as the Great Deleveraging, the Great De-risking and the Great Downsizing continue. This is the necessary and inevitable corrective process for the Great Credit and Consumption Bubble and it will, unfortunately, overshoot to the downside. In the end, however, a new and hopefully more sustainable equilibrium will be achieved.

In the meantime, though, we do not believe the mortgage stimulus now being discussed, which could lower interest rates on new 30-year fixed mortgages to 4.5%, is a fix that will turn around even the housing market, much less the rest of the economy. A fix that is not applied to existing mortgages to head off accelerating foreclosures will be too little, too late. New home buying may be stimulated, but people have less to spend and the supply of existing homes on the market will keep new home prices so low that margins will continue to inhibit building. Just like the fixes applied a year ago, this one, too, will fail.

About the Author

Since 1995, The Spear Report has published a weekly newsletter that has guided investors with our unique Consensus methodology. We also offer a daily Professional Edition, an Options newsletter, an ETF newsletter, and a Security Industry newsletter.

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